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Defensive Investing: Covered Calls Increase Cash Flow, Up Protection

[Editor's Note: In this latest installment of Money Morning's "Defensive Investing" series, options expert Larry D. Spears shows investors how the use of a "covered-call" options strategy can provide both protection and profits during uncertain market times.]

Once you get beyond buying puts or calls for purely speculative purposes, no other options strategy is more popular than selling covered calls – and with good reason: Few investment techniques offer more potential benefits with such a low level of risk.

Considered the most conservative of all option plays, this strategy – which basically involves selling (or "writing") one call option for each 100 shares of a stock you own – can be employed for one or more of five distinct purposes:

  1. To generate a stream of additional income – over and above dividend payments – from individual stocks in your equity portfolio.
  2. To generate a stream of income from stocks you own that pay no dividends.
  3. To reduce the effective cost basis of longer-term stock holdings by bringing in option premiums, thus recovering some of the original purchase price.
  4. To provide a limited hedge against potential losses in portfolio value as a result of overall market pullbacks or cyclical downturns in the prices of specific stocks.
  5. As an income-producing substitute for a "limit-sell order" – intended to liquidate a stock position when a specific profit target is achieved.

That's a fairly impressive list of potential benefits for a strategy that essentially costs nothing more than a modest commission – i.e., the position carries no additional margin requirement because the stock you hold "covers" the call option you sell. Plus, the play really has just two potential risks:

  1. You lose money if the price of the underlying stock falls – but less than you would have lost holding only the stock, since the loss is reduced by the amount of option premium received.
  2. The price of the underlying shares rises above the strike price of the call and you are forced to sell your stock at a profit (or buy the call back just before expiration, when it has little remaining time value).

If you're not entirely familiar with options and their terminology, a couple of examples should help clarify what's involved in structuring a covered-call position and demonstrate how it works. (For simplicity and ease of calculation, we'll use a 100-share lot of stock and a single call option in our examples, both of which are based on actual intraday prices from Tuesday, Oct. 19).

Assume you own 100 shares of Wells Fargo and Co. (NYSE: WFC), which you bought in June at $26 a share in anticipation that the company would start raising its annual dividend, which it slashed from $1.36 to just 20 cents in early 2009, and the stock price would rise as a result. You still think both will happen at some point, but neither has so far – the stock stood at just $24.90 on Oct. 19, and the 20-cent dividend provided a yield of just 0.76% on your original purchase price.

Defensive Investing
You'd like a bit more income from your investment in the meantime, and you're also a little concerned that the stock price might pull back further since the overall market had a good run-up in September and early October, but the bank stocks generally lagged, beset by ongoing woes over home foreclosures.

Selling your shares would protect against a further price retreat, but you'd take a loss, plus you'd give up your dividend income stream, small as it might be. Buying a protective put option would also hedge your position, but a three-month at-the-money put would cost a whopping $185 – hardly a bargain since the stock would have to fall to $23.15 before the protection even kicked in.

So, what can you do?

The answer's simple. Just write a covered call option against your stock – a call that's currently out of the money, meaning it has a strike price higher than the present price of your Wells Fargo shares.

With WFC at $24.90, that would mean selling either the $25.00 call or the $26.00 call, focusing on the options that expire in January (given the modest volatility of WFC stock, the November and December calls have too little time value remaining to make the sale worthwhile). A check of the WFC option tables shows that those two calls are priced at $1.84 ($184 for a full contract) and $1.30 ($130), respectively. Given that you feel the downside risk isn't severe and you originally bought at $26 a share and would like to at least break even if you have to sell, you decide to write the January $26.00 call for $130.

The immediate impact of this action is that you add $130 (less a small commission) to the income stream you receive from the WFC dividend, lifting your total for the year to $150 ($20 + $130 = $150) and increasing your annual yield to 5.76%.

Or, looked at another way, you reduce your effective cost basis on the 100 shares of WFC from the original $26.00 to $24.70. Or, looked at still another way, you protect yourself against a pullback in the WFC stock price from the current $24.90 to $23.60.

Finally, should you be wrong and WFC rally to a level above $26.00 on the expiration date (the third Friday of January 2011), you've locked in an additional profit from current levels of $2.40 – the $1.10 rise to the $26.00 strike price, plus the $1.30 you received for selling the call – the equivalent of an increase in the stock price to $27.30.

The table below, which shows the possible outcomes for this position at various WFC stock prices on Jan. 21, 2011, should clarify the hedging and profit potential of the covered call sale. The profit and loss numbers reflect changes from WFC's Oct. 19 intraday price of $24.90:

If Wells Fargo's stock remains below $26.00 a share on Jan. 21, 2011 – meaning the call option expires worthless and you get to keep your shares – you can then turn around and sell the appropriate out-of-the-money April call, adding still more to your income stream. And, you can continue doing so at least four times a year – until WFC finally rises above the strike price of the option you sell and your shares are "called away."

Keeping Your Options Open
(Note: If you are forced to sell your shares, you can offset the lost income stream by using the money you receive for them as security for the sale of out-of-the-money put options, the premiums on which will far more than make up for the WFC dividends you no longer receive. This strategy – known as selling cash-secured puts – is discussed in a past Money Morning article.)

As noted earlier, selling covered calls can also be used to generate an income stream from stocks that don't pay a dividend – a strategy that can produce a fairly high yield on lower-priced issues. An example might be computer giant Dell Inc. (Nasdaq: DELL).

On Monday, Oct. 18, DELL shares closed at $14.66, up from the prior Friday's close of $14.49. (Note: From a timing perspective, the best time to write calls is late in the market session on a day when both the major indexes and the specific stock are sharply higher – especially if that move has carried the stock to an area of technical resistance, such as a prior cyclical or 52-week high.)

A check of the Dell option tables showed that the nearest out-of-the-money call, the November $15.00 call, was priced at 51 cents, or $51 for the full 100-share contract, and the January 15 call was quoted at 83 cents, or $83. (Note: Dell options are on a February-May-August-November expiration cycle, so the December call was very thinly traded and not well suited for this strategy.)

You opt for the January $15.00 call, bringing in $83 – which amounts to a yield of 5.66% on the current share price. Plus, you get downside protection to a stock price of $13.83 ($14.66 – $0.83) – or, if Dell rises, an additional profit up to $15 a share (the call's strike price), plus the 83-cent premium.

Covered call writing is really a fairly simple process, but it can add significantly to the overall cash flow from your portfolio – and it carries less downside risk than holding stocks alone. The only additional risk factor over holding shares alone is that you'll miss out on some of the profits if the underlying stock moves sharply higher, putting the call in the money and forcing you to sell your shares at the option strike price (or buy back the call just prior to expiration).

For that reason, most investors view covered call writing as a strategy best suited for flat or mildly bearish market conditions. However, if you pair it with an alternating program of selling cash-secured puts whenever one of your stocks is called away, it can be a steady – and highly profitable – technique in virtually any market environment.

[Editor's Note: Article author Larry D. Spears is an options expert. A veteran journalist and longtime chronicler of the global financial markets, Spears has also written several books on financial topics – including the options-strategy primer: "Commodity Options: Spectacular Profits With Limited Risk." In an earlier contribution to Money Morning's "Defensive Investing" series, Spears illustrated how options "insurance" could protect investors against short-term pullbacks.]

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